Opinions Divided on Narrowing of SEC’s Power

In a decision likely to reach the U.S. Supreme Court, a federal appellate court has ruled that the Securities and Exchange Commission’s (SEC) administrative proceedings violate litigants’ constitutional right to a jury trial, exceed congressionally delegated powers, and violate executive powers granted only to the president. Just as Jarkesy v. SEC had a robust dissent, so too are ABA Litigation Section leaders divided on some of the issues presented in the appeal. All leaders agree, however, that the opinion reflects a trend toward courts limiting the congressionally delegated powers of administrative agencies.

A Procedural Road Map for Securities Fraud

In Jarkesy, the SEC brought an agency enforcement action for securities fraud against the defendants, a fund manager who established two hedge funds and the manager’s investment advisor. The SEC alleged, among other things, that the defendants misrepresented the funds’ investment parameters and safeguards and overvalued the funds’ assets to increase their investor fees, in violation of federal securities laws.

The defendants sought to enjoin the SEC proceeding against them and sued in the U.S. District Court for the District of Columbia. They alleged that the SEC infringed on various constitutional rights by bringing the administrative proceeding. Both the district court and the U.S. Court of Appeals for the D.C. Circuit declined to issue an injunction on the basis that they had no jurisdiction and ordered that the defendants had to continue with the SEC’s administrative proceeding and appeal any final decision to the D.C. Circuit.

The defendants continued with the agency proceeding. An SEC administrative law judge (ALJ) found that the defendants had committed securities fraud. Following the standard appeals protocol for SEC administrative matters, the defendants appealed to the SEC itself.

While the defendants’ appeal was pending with the SEC, the U.S. Supreme Court decided Lucia v. SEC, which held that SEC ALJs are “officers of the United States,” pursuant to Article II, Section 2, Clause 2, of the U.S. Constitution—and not mere employees—and thereby may be appointed only by the president consistent with the Appointment Clause. To comply with Lucia, the SEC assigned the defendants’ proceeding to a properly appointed ALJ, but the defendants waived their right to a new hearing and continued with their original petition to the SEC.

The SEC affirmed the ALJ’s finding of securities fraud and ordered the defendants to cease and desist from committing fraud, disgorge over $600,000 in ill-gotten gains, and pay a civil penalty of $300,000. In ruling against the defendants, the SEC rejected the defendants’ arguments that the SEC proceedings violated their Seventh Amendment right to a jury trial, that the SEC exercised unconstitutionally delegated legislative powers, and that the removal restrictions on ALJs violated Article II separation-of-powers principles. The defendants then sought review of the SEC’s ruling in the U.S. Court of Appeals for the Fifth Circuit.

Absence of Jury Trial Unconstitutional

One key issue in the Fifth Circuit was whether the SEC’s administrative proceedings denied the defendants the right to a jury trial. Citing numerous treatises for the proposition that the right to a jury trial emanates from the English common law, the Fifth Circuit began its analysis by noting that Congress “or any agency acting pursuant to congressional authorization[] cannot assign” common law claims to an agency because such claims “do not concern public rights alone.”

Further, the court noted that the Seventh Amendment right to a jury trial attaches to lawsuits brought under civil penalty statutes. In doing so, it cited U.S. Supreme Court precedent in Tull v. United States, which held that the Seventh Amendment guarantees a jury trial in actions involving the government that seek a civil penalty and emanate from the common law.

Although the right to a jury trial attaches where “public rights”—and not just individual common law rights—exist, the court cited the U.S. Supreme Court case of Atlas Roofing Co. v. OSHA for the proposition that Congress may nonetheless assign the jury’s fact-finding function to an administrative agency. In Atlas Roofing Co., the Supreme Court held that Congress created a new statutory duty—that amplified state common law negligence and wrongful death actions—to “avoid unsafe or unhealthy working conditions,” and delegated the power of enforcing this new duty to the Occupational Health and Safety Agency (OSHA).

Further, said the court, the U.S. Supreme Court refined the “public rights” concept in Granfinanciera, S.A. v. Nordberg, which reasoned that Congress cannot avoid the Seventh Amendment jury trial right by assigning common law claims to an administrative agency. A public right is only appropriate for administrative resolution, said the court, if Congress created a statutory cause of action that was nonexistent at common law and a jury trial would dismantle the “statutory scheme” or “impede swift resolution” of a case as set forth by Congress in a particular statute.

Here, the court concluded that fraud cases were routinely litigated at common law. Moreover, citing Tull, the court observed that, at common law, civil penalties could be enforced only in courts of law. Quoting Granfinanciera, the court concluded that, in the securities fraud context, a jury trial would not “dismantle the statutory scheme” or “impede swift resolution” of statutory claims. Therefore, the court held that the defendants had a right to a jury trial to determine the facts underlying the fraud claims and the liability imposed on them.

The dissent, however, argued that the majority creatively misread Atlas Roofing and Granfinanciera as holding that SEC enforcement actions do not involve “public rights.” Instead, the dissent read those opinions as countenancing SEC enforcement actions as “public rights,” since such actions emanate from statutes Congress—a publicly elected body—enacted. Accordingly, the dissent concluded that the Seventh Amendment does not prohibit Congress from “assigning [SEC enforcement actions] to an administrative forum that lacks a jury.”

“The majority correctly determined that the standard for preservation of the right to trial by jury must be upheld when an individual’s interests are at stake and where the issues existed under the common law,” explains Mark A. Romance, Miami, FL, cochair of the Litigation Section’s Commercial & Business Litigation Committee. “This ruling still allows Congress to enact laws that streamline resolution of disputes through administrative (nonjury) proceedings but protects an individual’s right to a jury trial where the government seeks relief from individuals under new regulations that mirror claims that existed under the common law,” Romance reiterates.

While agreeing with the court’s general conclusion that securities fraud claims existed at common law and are entitled to Seventh Amendment protection, Matthew P. Allen, Detroit, MI, cochair of the SEC Enforcement Subcommittee of the Section’s Securities Litigation Committee, thinks the issue of whether securities fraud cases are not “public right” cases is a murky issue. “The closer question may be the court’s holding that securities fraud cases brought by the SEC are not ‘public rights’ cases simply because an agency of the government brings them,” posits Allen. Observing that the dissenting opinion interpreted Atlas Roofing and Granfinanciera as implicating public rights that do not require a jury trial, Allen opines that, “if the case is appealed to the Supreme Court, I am not sure the current Court would agree that a regulatory agency is akin to ‘the Government in its sovereign capacity.’”

Congress's Delegation of Legislative Powers Unsettled

Not only did it reject the SEC’s Seventh Amendment jury trial conclusion, the court also found unconstitutional Congress’s delegation of legislative power that gave the SEC “unfettered authority to choose whether to bring” an action in federal court or within the agency. Quoting Article I, Section 1 of the U.S. Constitution, the court stressed that “all legislative powers” are vested in Congress. Referencing Supreme Court precedents, the court wrote that two elements must be present for limited delegatory power to exist in an agency. First, Congress must delegate power that “would be legislative power but for an intelligible principle to guide its use.” Second, such “intelligible principle” must guide an agency to exercise “only executive power”—since only Congress may exercise legislative power at the federal level.

Applying the foregoing principles, the court concluded that Congress did delegate legislative power to the SEC but without an “intelligible principle,” contrary to Article I, Section 1 of the Constitution. Therefore, the court vacated the SEC’s ruling on the foregoing constitutional ground as well.

On this issue, the dissent rejected the majority’s reliance on the Supreme Court case of Crowell v. Benson, which reasoned that the “mode of determining” which cases involve public rights is “completely within congressional control.” According to the dissent, Crowell did not narrow congressional authority as the majority posited. Instead, the dissent concluded that the SEC’s prosecutorial mandate permitted the agency to determine whether it would bring a case in federal court or within the agency.

Section leaders have mixed observations on the delegation issue, with some thinking this court settled the issue and others intimating the Supreme Court may soon intervene. “This decision requires Congress to provide limits to agency power, and its failure to do so leaves the agency action subject to challenge,” observes Romance. “To the extent Congress enacted additional laws that afford agencies with discretion without sufficient parameters, the agencies’ actions are subject to constitutional challenge,” Romance adds.

Allen likewise thinks this may be a settled issue. “As to the delegation of power question under Article I of the Constitution, I think it is close, but I think the majority got it right in determining that the delegation to the SEC of whether to sue someone in federal court or in its own administrative tribunal is different than a traditional executive function of prosecutorial discretion,” Allen asserts.

Achyut J. Phadke, San Francisco, CA, cochair of the Section’s Securities Litigation Committee, does not believe the delegation issue has been or is close to being resolved with this opinion. “The non-delegation ruling is something of a surprise,” declares Phadke. “The Supreme Court hasn’t issued a ruling striking an administrative statutory scheme on non-delegation grounds since the 1930s, and this looks like an attempt to revive that body of law. Four sitting Supreme Court justices (Chief Justice Roberts and Justices Thomas, Gorsuch, and Alito) expressed interest in reconsidering the scope of the non-delegation doctrine in Gundy v. United States in 2019, and this aspect of the Jarkesy ruling may reflect a broader judicial interest in looking at that doctrine as something that actually has teeth,” Phadke predicts.

Opinion Portends Trend in Limiting Agency Powers

A final constitutional defect the court found in the SEC’s proceeding concerned the appointment of SEC ALJs. Since SEC ALJs exercise “substantial executive functions,” said the court, the president should appoint ALJs. Quoting Article II, Section 3 of the U.S. Constitution for the principle that the president must “take care that the laws be faithfully executed,” the court explained that proviso also grants the president power over officers’ removal and appointment. “Only then,” wrote the court, “can the People to whom the President is directly accountable[] vicariously exercise authority over high-ranking executive officials.” Citing Supreme Court precedents, the court noted that “inferior” and “principal” officers of the United States may retain “for cause protection” against termination from employment.

However, the court noted that in Free Enterprise Fund v. PCAOB, the Supreme Court rejected the layered, for-cause protection for members of the Public Company Accounting Oversight Board, whose members could be removed from the board by SEC commissioners, only if members committed certain willful or unreasonable acts. The president could only remove SEC commissioners, in turn, for negligent or inefficient conduct. The Free Enterprise Court held that the foregoing layered removal of board members interfered with the president’s constitutional authority to “take care that the laws be faithfully executed.”

Here, similar to board members in Free Enterprise, SEC ALJs have two layers of for-cause protection, said the court. Specifically, the court noted that, since ALJs are “inferior officers,” they can only be removed by SEC commissioners if “good cause” is found by the Merit Systems Protection Board (MSPB). And SEC commissioners and MSPB members can only be removed by the president for cause. Applying Free Enterprise, the court concluded that the president does not have the necessary power to “take care that the laws be faithfully executed,” contrary to the Constitution. The dissent took a broader view on this issue and did not read Free Enterprise as declaring layered removal of inferior officers as unconstitutional.

According to Section leaders, Jarkesy reflects a trend in courts toward limiting powers of administrative agencies—an issue that may soon reach the Supreme Court. “The Article II question of whether the restrictions on removing SEC ALJs deprives the president of the ability to faithfully execute the law is a hot issue,” explains Allen. “The Supreme Court recently agreed to hear SEC v. Cochran, which will decide whether a respondent in a pending SEC administrative case may sue the SEC in federal court to challenge the constitutionality of the restrictions on removal of SEC ALJs,” Allen adds.

Vincent (Trace) P. Schmeltz, Chicago, IL, cochair of the SEC Enforcement Subcommittee of the Section’s Securities Litigation Committee, thinks the court’s decision is part of a trend to limit litigation of high-money claims in administrative forums. “Jarkesy reflects a seven- or eight-year full-frontal assault on the enforcement of high-stakes federal laws seeking severe monetary penalties by administrative law judges,” Schmeltz observes.

Another Section leader identified the material impact of Jarkesy. “Since the Jarkesy decision came down, my partners and I have noticed a distinct change,” observes Kirsten Patzer , Boston, MA, cochair of the Women in Securities Litigation Subcommittee of the Section's Securities Litigation Committee. “The SEC is not bringing administrative matters, instead filing in federal court and requesting jury trials in actions they historically would have kept inside,” Patzer concludes.